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Will the Fed’s new policy framework bring higher inflation?
Timothy Ng
Portfolio Manager
KEY TAKEAWAYS
  • The US Federal Reserve’s willingness to tolerate higher inflation may keep policy loose for an extended period. 
  • Accommodative policy and a weak labour market are likely to keep bond yields low. 
  • Inflation risk is skewed to the upside over the longer term.

Will the Fed’s new policy framework bring higher inflation?


In January, the US Federal Reserve affirmed its commitment to low interest rates for a prolonged period of time under its new monetary policy framework. If anything, with its renewed focus on “broad-based and inclusive” maximum employment and a goal of achieving inflation that averages 2% over time, the Fed has made the conditions for policy removal more stringent. Speaking after the meeting, Chair Jerome Powell stressed the importance of “substantial further progress” towards the employment and inflation goals before the Fed would consider adjusting its policy stance.


Here’s my current thinking on inflation expectations and where Treasury yields could head in the near and medium term.


Temporary bumps in inflation may occur


Consumer prices have recovered from recent lows as economic restrictions have been lifted. Still, they remain below pre-COVID levels. Looking ahead, I expect that core PCE (Personal Consumption Expenditures, the Fed’s preferred inflation gauge) will accelerate temporarily above 2% in the spring of 2021 but will likely decelerate toward the end of the year as low inflation data from 2020 rolls off. Similarly, the economy may experience temporary bumps in inflation as it reopens.


Many households shored up their savings over the past year, and we could see a release of pent-up demand and consumers re-engaging in select services. However, that impulse is unlikely to last unless there is a sustained and robust economic recovery.


Elevated household savings could fuel a burst of spending


US personal saving rate1


Accommodative policy and a weak labour market are likely to keep bond yields low


More “reactive” policy. As part of its year-long framework review, the Fed adopted a monetary policy prescription that it said will be more “reactive” and less “proactive” regarding economic outcomes. In recent speeches, Powell has de-emphasised the Fed’s reliance on models such as the Phillips curve in guiding policy decisions, due to the uncertain and imprecise cause-and-effect relationships underlying them. (The Phillips curve is an economic concept stating that inflation and unemployment have a stable and inverse relationship.)


Furthermore, Powell stresses the importance of seeing desired economic outcomes materialise before making policy changes. One lesson from the previous rate cycle was that the Fed’s dependence on such models led it to hike rates far too soon in fear of inflation that never materialised. It raised rates by 200 basis points over two years starting in December 2016, then had to readjust policy by cutting rates three times in 2019.


Slow recovery in the labour market. The labour market has been slow to heal and is unlikely to meet the Fed’s newly adopted definition of “broad-based and inclusive” maximum employment anytime soon. Recently, the Fed strengthened its employment mandate as part of its policy framework review, putting it ahead of its inflation goal and emphasising that policy decisions will aim to address only “shortfalls” in the employment goal.

1. Source: US Bureau of Economic Analysis, retrieved from FRED, Federal Reserve Bank of St. Louis. Seasonally adjusted annual rate. As at December 2020.

1. Source: US Bureau of Economic Analysis, retrieved from FRED, Federal Reserve Bank of St. Louis. Seasonally adjusted annual rate. As at December 2020.


 


Risk factors you should consider before investing:

  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
  • Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.


Timothy Ng is a fixed income portfolio manager with 15 years of industry experience (as of 12/31/2020). He holds a bachelor's degree with honors in computer science from the University of Waterloo, Ontario.


 

Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.